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Contribution Margin

 

Contribution margin [CM] is defined as the difference between revenues and variable costs. CM can be calculated on a total or per unit basis.

Assume we have a selling price of $100/unit and per-unit variable costs of $50 for labor, $10 for supplies, and $15 for sales commissions. Therefore, total variable costs per unit are 50+10+15 = $75. Contribution margin per unit is 100 - 75 or 25. if we sell 20 units of product, total revenues are $2,000 [20 * 100] and total variable costs are 75 * 20 or $1,500. total contribution margin is 2,000 - 1,500 or $500. Note that we could have found the total CM by multiplying the $25 per unit CM by the 20 units sold [20 * 25 = 500].

Two important ratios can be derived if we know contribution margin and variable costs [VC]. Note that contribution margin and variable costs are complements of revenue [R]:

R - VC = CM, but R - CM = VC.

Therefore, the ratio of contribution margin to revenue [CM/R] plus the ratio of variable costs to revenue [VC/R] will always equal 1.0 or 100%.

Contribution margin is what is left over after we subtract variable costs from revenues; the contribution margin ratio [CMR] is the proportion of revenues that are left to cover fixed costs and profit, after subtracting variable costs. Conversely, the variable cost ratio [VCR] is the proportion of revenues that are eaten up by variable costs. The bigger the VCR, the less contribution is left over to cover fixed costs and profit.

Now that you understand contribution margin, we can move to a description of a contribution margin income statement.

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Copyright 2004 Gerald M. Myers. All rights reserved. This site has been developed as aid to instructors and students in managerial accounting. The scenarios contained herein are not intended to reflect effective or ineffective handling of managerial situations. Any resemblance to existing organizations is purely coincidental.
Last modified: August 03, 2005